The Basics of Investing

Student Editor: Dillon H.

What is investing? Well, the word invest comes from the old latin ‘in-‘ meaning ‘upon’/’in’ and ‘–vestire’ meaning ‘clothed’. So when someone becomes a soldier or a judge or senator, they are given a special clothing (a uniform) to show that they have been given a certain role and authority. Thus, to invest in something means to cover (mark) it with trust and to signal a belief in the ability of it to perform a desired function. We still use the term investing in this sense, for example when we invest police officers with the authority (power) to execute enforcement of the law. 

In terms of financial investing, we mean to say that when we buy an asset (when we place our money [and financial potential] in it) we do so because we trust and believe it will increase in value in the future. When the asset increases in value, we can then sell it for more than we had originally paid for it. When this happens, we have increased our net worth and made a profit. So by definition, investing is the purchase of a monetary asset (anything that you can buy and sell for cash or else trade for assets of fair value) based on a well-founded belief that the asset will increase in value over time.

Like saving, investing is a critical element of establishing your financial security. Unless you are lucky enough to be a lottery winner (financial, genetic, or otherwise ), your lifetime income from work will most likely be insufficient to provide for your retirement. This means that you will have to practice saving and investing behaviors in order to provide for your expenses. Remember that in retirement, you will not be working and so you need to find an alternative way to make money. Investing is the answer to how you will make money without working. 
In a broad sense, anytime that you purchase an asset with the expectation that it will increase in value over time, you are making an investment. So you can make investments grounded in various features of an asset, such as scarcity (diamonds), aesthetic value (artwork), profit potential (securities, bonds and financial investments in general). We will be focusing on the latter, financial investments. The most common forms of financial investments are equities (stocks), bonds (government debt and corporate debt), and commodities (such as oil, corn, pork bellies [bacon], coffee, gold).

stock exchange/bulls

A stock, also called a share, is a certificate of fractional ownership in a corporation. You can buy stocks in both private and publicly traded corporations. When you buy a stock, you receive a share of the corporation’s profits that is proportionate to your ownership of the corporation. In addition to a share in the profits, in many cases you also have a right to vote in corporate elections and ballots. You typically get one share for each individual stock you own. So it is not exactly a democratic procedure. It does however give investors an opportunity to publicly express their opinions and desires to the board of directors (senior corporate leadership) concerning any aspect of the business. 

A bond is a certificate of ownership for a specific amount of debt held by a government or corporation. Governments and companies use this money to fund their operations (i.e. building public infrastructure and expanding corporate activities). Essentially, when you buy a bond, you are lending to a government or corporation your money with the promises that they will pay you interest on the loan for a specific period of time. At the end of that period, they will also repay your original principal investment.

For example, if you buy a $1,000 ten-year bond from the US Government with a 10% interest rate, you will be paid $100 per year for ten years as well as your original $1,000 at the end of the ten-years. In this example, you would have made a 100% return over 10 years (or $2,000). Buying corporate (private) debt works in basically the same way. One thing that is special about government (public) debt, is that you do not have to pay taxes on earnings on them. In addition, if you buy what are called ‘general-obligation’ bonds, you are guaranteed that even if the bond you bought fails, the government will repay your principle investment. So like every investment, knowing what you are buying is of the upmost importance. 

squirrel with gold peanunts

A commodity is typically a raw material (gold, corn, oil, soy beans) that you buy in a standardized quantity with the idea that it will have high-demand (and thus high prices) in the future market. The value of commodities is often tied to the scarcity of its availability in the market. This can be due to production levels, increased demand, or even climatic factors (such as drought). For instance, if you know that there is going to be a drought that results in a small crop for corn next season, you would buy bushels of corn knowing that there would be more demand for it than supply in the market. In such a market scenario, you can sell your commodity at a higher price than normal because there are many buyers competing for ownership of it. 

Because the economy goes through periods of growth and recession, it is important to invests in more than one company and, in fact, in more than one type of investment (ie buy stocks and bonds and some corn). Doing this is important because it will protect you from being wiped out if any one of your individual investments fail. This practice is called asset diversification. If you are well diversified, you will be able to insure that you can survive occasional losses and grow your wealth smoothly over time. 

Before you start investing, it is important to reflect on your personality. Are you a risk taker or do you prefer to have few surprises? Would you rather actively manage your investments or would you prefer to take long-term positions and only need to check in from time to time to see how your investments are doing? Are you financially aggressive or conservative? Remember that you can lose everything you invest when you buy stocks. So if you own stock in a company that goes bankrupt, the money you invested in the company will go to pay the company’s creditors (the people the company borrowed money from). Some companies are involved in riskier businesses than others, this is something you should analyze and think about before buying a share of a company. 

In addition to knowing your risk profile, you need to study several things about any asset before you decide to invest in it:

First you need to study the financial situation of the asset. For example, if you are considering buying shares in a company, you need to check whether the company is financially stable. Are they in debt? How have they performed in the past? What are the chances that they will be profitable in the near/long-term future? Is there anything going on in the world that might positively or negatively impact the company’s performance? 

Secondly, you need to look at the market for the asset type over all. For example, check to see whether the market is at an all-time high. Often this is not the best time to buy into a market. Because the economy (and thus the market) runs in cycles of boom and bust, buying into an asset at record high prices (also called ‘peak markets’) can often result in your investments losing short-term value. Overtime they might go up, but you have lost the ability to generate income in the meantime because your money is tied-up in an asset that is cooling off from record high prices. 

Thirdly, never make financial decisions, including investing decisions, based on emotions. Whenever you decide to invest in something, the reasons that you think it will increase in value need to be based in objective facts and sound reasons. So just liking a company or thinking that their product is great is not enough. You need to look at their financial details to determine whether the business will be profitable. Popularity is no determinant of financial success.

Likewise, you should not make decisions to buy or sell assets out of excitement or fear. Investing is not gambling and all decisions should be based on research and pre-arranged plans for any given scenario. Oftentimes, people will sell everything in a falling market and stay on the side-lines only to find that the market has recovered 6 months to a year later. As a basic rule-of-thumb, the idea is to buy something of real value with good foundations; to buy it at a low price and sell it at a higher price; and to diversify your investments to provide for growth no matter what market forces prevail. 

Finally, remember that your risk profile will change while you age. More aggressive and risky investment strategies are reasonable when you are young. This is because you have the time and opportunity to grow and rebuild wealth. When you are older, however, you will want to become more conservative in your investments. Because you cannot go out and get a job and cannot wait to rebuild your wealth when you are older, you will have to avoid investing in assets that might go belly-up (fail). All you will need at this later stage is investment stability and modest interest payments that will cover your day-to-day expenses.  

You can never be too young to start investing, however you should never invest blindly. If you internalize a few of these simple lessons and get in the habit of researching before you buy, the likelihood that you will make good investments will certainly increase. So start thinking today about the kind of investor you are and how you will go about building your investment portfolio. Go out and carpe diem, or as we say now-a-days, YOLO! 

*‘Carpe diem’ is an old Roman idiom meaning ‘seize the day’. Popularized by the 1st century BC poet Horace, it first appears in book one of his epic The Odes: “Be wise, strain the wine; and since life is brief, prune back far-reaching hopes! Even while we speak, envious time has passed: seize the day, putting as little trust as possible in tomorrow!” Note: a literal translation would read ‘pluck the day’, which makes sense as the phrase appears in a farming metaphor.